China’s Bitter Medicine for Foreign Drug Companies

The Chinese government’s actions against foreign drug makers emerged like a late summer Beijing storm: heavy drops slapping slowly at first, then all at once becoming a disorienting deluge, pounding down in every direction.

The turmoil began on July 2, with an announcement from the National Development and Reform Commission (NDRC), the country’s top economic planner, that it would examine 27 drug manufacturers for issues related to costs and 33 for issues related to pricing. On July 15, China’s Ministry of Public Security said it had detained four senior executives from British drug maker GlaxoSmithKline (GSK) for bribing doctors and hospital officials using $489 million in fraudulent transactions funneled through travel agencies. Then, one after another, in the Guangzhou-based newspaper 21st Century Business Herald, a series of whistleblower bribery allegations rained down on Paris-based drug maker Sanofi, Swiss pharmaceutical company Novartis and Indianapolis, Ind.-based Eli Lilly & Company.

The forces driving the storm are many, from a broken health care system and the tensions of a slowing economy to profit pressures within the pharmaceutical industry itself, say Wharton professors and other experts. Yet from whatever angle the onslaught arrives — via court judgments, anti-monopoly investigations or even attacks on company patents — the objective appears to be the same: to reduce the prices of drugs and other daily necessities for China’s 1.3 billion people.

“[Chinese President] Xi Jingping is trying to reach out to the economically squeezed middle class,” says Wharton management professor Marshall W. Meyer. “Housing and food costs continue to escalate, and other retail prices, at the current RMB-dollar exchange rate, seem much higher than in the U.S.” On top of that, the pricing of non-generic drugs in China has been called “irrational,” Meyer notes. “In the past, hospitals have operated on an inside-contracting system, so one of the few opportunities to make money has been drug sales.”

The majority of China’s hospitals are state-run and underfunded, according to an analysis by The Associated Press. Prices for many services are set far below actual cost, leaving hospitals with gaps that they fill by adding surcharges on drugs, assigning sales quotas or prescribing expensive treatments. Most of the nation’s 2.3 million doctors are also underpaid, yet barred from earning outside income. An experienced physician makes about 6,000 yuan ($980) a month.

Most Western countries spend 10% to 12% of their health care budgets on medicine, but in China it is more than 40%, according to Reuters. The most recent edition of the World Health Organization’s World Medicines Situation Report, published in 2011, said that medicines account for 43% of China’s total health expenditures.

“China’s model for funding health care does not work,” states Wharton professor of legal studies and business ethics Philip M. Nichols. “So, health care providers must find outside, often informal, ways of obtaining resources. Among those sources are the bribes paid by pharmaceutical firms.”

Liang Hong, one of the GSK executives detained in the current probe, was quoted by China’s state-run media as saying that the costs of the bribes were eventually wrapped up into the price of medicines, accounting for up to 30% of a drug’s final price.

In a GSK statement issued on July 22, Abbas Hussain, president international of Europe, Japan, Emerging Markets & Asia Pacific, said the company would “actively look at our business model,” adding that “savings made as a result of proposed changes to our operational model will be passed on in the form of price reductions, ensuring our medicines are more affordable to Chinese patients.”

Patents under the Microscope

When it comes to bringing down prices for consumers, Chinese authorities are not limiting themselves to bribery investigations. China’s State Intellectual Property Office (SIPO) recently declared the patent for the drug Viread to be invalid, a move that will likely halve the drug’s current monthly price of 1,470 yuan ($240), according to biotechnology news service BioWorld.

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Viread (tenofavir disoproxil fumarate), produced by Foster City, Calif.-based Gilead Sciences, is used to treat chronic hepatitis B, and in combination with other anti-retrovirals, is also used as a treatment for HIV. More than 30 million people in China have chronic hepatitis B — a third of the world’s total cases — and HIV/AIDS caused 11,575 deaths in China in 2012, nearly a 25% year-on-year increase, according to research firm IHS Global Insight.

Alfred W. Zaher, a patent attorney at Blank Rome LLP in Philadelphia, argues that there is nothing wrong with Gilead’s patent, which SIPO declared invalid for a lack of novelty. “Most patent practitioners would likely view this as an incorrect decision under accepted patent law principles,” he says. “This is clearly not a patent law decision…. It is an economic decision and a warning to other drug companies … to lower the price of premium patented drugs in China or risk being stripped of all their rights.”

Authorities in other emerging markets have used intellectual property rights to push down drug prices, according to FiercePharma, an industryblog. For example, India recently pulled patents for Roche’s Herceptin and GSK’s Tykerb, two breast cancer drugs. Gilead began offering heavy discounts on Viread in China last year, reportedly giving the government a two-for-one deal on the drug, FiercePharma reported.But clearly the changes were not enough.

A Question of Antitrust

China antitrust authorities have also been heavy handed, pursuing a string of actions in the medical sector and other industries against resale price maintenance (RPM), sometimes called vertical price-fixing, in which a manufacturer prevents distributors from selling its products below a certain price.

Resale price maintenance is no longer unlawful in the U.S.,but it is subject to a “Rule of Reason” analysis, notes Wharton adjunct finance professor Martin Asher. “Both the economics literature and the courts have recognized that under some circumstances, a manufacturer’s wish to charge a particular price could be efficient — particularly in cases where the product comes along with significant services or information provided by the retailer,” he says. “Courts now seek arguments from both sides on the pro-competitive and anti-competitive effects of RPM in each situation.”

“This is a warning to other drug companies … to lower the price of premium patented drugs in China or risk being stripped of all their rights.” — Alfred W. Zaher

However, events in China indicate that antitrust authorities there may be taking a harsher stance. On August 7, the NDRC slapped a total of $110 million in fines on six manufacturers of powdered infant formula, including Illinois producers Abbott Laboratories and Mead Johnson Nutrition, for “various forms of resale price maintenance” that the commission said violated China’s Anti-Monopoly Law. All of the firms immediately slashed prices and said they would not contest the fine.

A week earlier, the Shanghai High People’s Court ruled that two subsidiaries of Johnson & Johnson engaged in monopolistic practices by setting a floor on the price of surgical staplers and suturing products being sold in in Beijing through a distributor. And China’s State Administration for Industry and Commerce on August 14 launched a three-month investigation of the pharmaceutical and medical device industries for anti-competitive practices, and said it was considering extending the probe into the banking, petroleum and telecommunications sectors.

Earlier this month, the European Union Chamber of Commerce in China complained that foreign companies were being unfairly targeted by the multiple bribery and price-fixing investigations.In addition to GSK, Sanofi, Novartis and Eli Lily, Chinese authorities have also made visits in recent weeks to the offices of Bayer AG and AstraZeneca.

“[It] is a little bit unfair … that the foreign companies which are the most serious about [standard operating procedures] have been the most investigated and the most discriminated [against],” says Bruno Gensburger, chair of the EU Chamber’s pharmaceutical working group. “We all want to work in a very clean environment…. [If] this campaign is aimed just to frighten some companies or create a special climate, I don’t think it will solve anything.”

At an antitrust forum held in Beijing on September 16, National Development and Reform Commission director general Xu Kunlin denied that authorities were only targeting foreign firms. Just days earlier, China’s state television aired an investigative report that raised bribery allegations against Chinese drug developer and producer Sino Biopharmaceutical. And privately held Gan & Lee pharmaceutical is also reported to be investigating allegations of corruption within its ranks.

Foreign firms say the ongoing pressure has put a damper on sales, as doctors at Chinese hospitals refuse to meet with drug representatives for fear of getting pulled into the next media exposé. According to a recent Reuters report, many foreign pharmaceutical companies are scaling back on sales quotas, and analysts expect to see a fall in sales in the third quarter.

A Blurry Line

Wharton marketing professor Z. John Zhang says that “it is hard to imagine” that big drug manufacturers actually break the law intentionally. The pressure that comes with selling prescription drugs in any country is high, he notes. “Given that a pharma company typically would spend more than $1 billion to develop a successful drug, you can imagine the kind of pressure that pharma salespeople are under to push their drugs through the distribution channels. That is why detailing [providing approved scientific information on a drug], frequent visits to doctors’ offices with samples and other promotional incentives” are major promotional practices everywhere in the world, he says.

“However, that is where the line between legal and illegal promotions can become blurry very quickly, especially in China,” Zhang adds. “It is easy for questionable practices to crop up without being noticed, and it is hard to guard against [the temptation] to overlook them.”

Chinese police recently accused GSK of coordinating bribery at the company level, designing questionable sales practices to meet annual sales growth goals of as high as 25% — a rate that is 7% to 8% above the industry average, according to state run news agency Xinhua. Police say GSK China’s salespeople invited doctors to meetings and then gave them “lecture fees” when no lectures were given, and offered gifts, dinners and even kick-backs for each prescription. A GSK spokesperson responded that the company remains “deeply concerned by the allegations of fraudulent behavior in our China business.”

“[The] line between legal and illegal promotions can become blurry very quickly, especially in China.” — Z. John Zhang

There are definitely lessons to be learned from the GSK case, Zhang says. “First, you always want to stay well within the legal boundary in detailing, even though it is very tempting to ‘do as the Romans do,’ so to speak,” he notes. “A Western company should periodically conduct independent ‘practice audits,’ preferably by someone from outside of China, to uphold its standards.”

Pharma companies should also not rely on salesperson-driven “push” promotions too heavily, Zhang advises. “’Pull’ promotions — or disseminating product information directly to patients and incentivizing them to ask for your drugs — can also do the job.”

According to Nicholas Chan, a partner at Squire Sanders law firm in Hong Kong, who has led numerous Foreign Corrupt Practices Act investigations in Greater China, the lesson that multinational companies should learn from the recent GSK case is that bribery is not worth doing. “If you continue to push the law, the law will catch up to you,” he says. “The lesson learned is to do things the right way.”

Chan adds that he has seen several cases of commercial bribery in China. One of the most common methods is to use inflated restaurant receipts to mask fraudulent transactions. He suggests that companies formulate strong compliance programs backed by a “robust compliance team that reports all the way up to the CEO.” Compliance programs with numerous checks and balances can prevent power from becoming too concentrated in the hands of one person or team, he notes. In many banks, for example, bankers are often required to take regular leave and rotate out of their positions frequently to prevent fraudulent behavior from going undetected.

“Apart from the local team, you might need a [person] who is not in the in-group, who has no attachment to the local team,” Chan says. “You can’t just have one guy sitting on his own empire for a long time.”

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